Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Reliance Steel & Aluminum Co. (NYSE:RS) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Reliance Steel & Aluminum's Debt?
The chart below, which you can click on for greater detail, shows that Reliance Steel & Aluminum had US$1.64b in debt in December 2020; about the same as the year before. On the flip side, it has US$683.5m in cash leading to net debt of about US$961.4m.
How Healthy Is Reliance Steel & Aluminum's Balance Sheet?
We can see from the most recent balance sheet that Reliance Steel & Aluminum had liabilities of US$613.0m falling due within a year, and liabilities of US$2.37b due beyond that. On the other hand, it had cash of US$683.5m and US$928.4m worth of receivables due within a year. So its liabilities total US$1.37b more than the combination of its cash and short-term receivables.
Given Reliance Steel & Aluminum has a market capitalization of US$9.90b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Reliance Steel & Aluminum has a low net debt to EBITDA ratio of only 1.0. And its EBIT covers its interest expense a whopping 11.2 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. The modesty of its debt load may become crucial for Reliance Steel & Aluminum if management cannot prevent a repeat of the 31% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Reliance Steel & Aluminum's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Reliance Steel & Aluminum recorded free cash flow worth a fulsome 92% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.
Happily, Reliance Steel & Aluminum's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But we must concede we find its EBIT growth rate has the opposite effect. All these things considered, it appears that Reliance Steel & Aluminum can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 3 warning signs we've spotted with Reliance Steel & Aluminum .
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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